Why Buy and Hold Is a Dreadful Mistake

by: Joseph L. Shaefer

There are three components to building a successful portfolio: periodic rebalancing (not to be confused with trying to time the market’s daily ups and downs), intelligent asset allocation and, finally, exceptional stock selection.

Buy-and-hold investors typically spend 0% of their time, energy and intellect on periodic rebalancing; 0% - 30% on asset allocation, and 70%-100% on stock selection. If they are mutual fund investors, they devote 0% on any of these, trusting the mutual fund managers to do all that. Instead, they spend – waste – 100% of their share-of-mind on picking the “best” mutual funds.

The financial media is only too happy to oblige, with scores of articles like, “Where to Put $1000 Today!” and “The Best Mutual Funds for 2009!” Mutual fund companies pay for a huge percentage of the ads in these media outlets. If you are a buy-and-hold investor, both the magazines, newspapers and web sites that publish this stuff, as well as the funds themselves, thank you for your misplaced trust and your well-entrenched laziness.

I believe that the rules that work in a bull market are turned on their head in a bear market. So buy-and-hold, hiding your head in the sand, and even asset allocation will disappoint. When the markets decline, they take the good and the great down right alongside the bad and the worst. Partly this is because of investor panic, more is because of institutional redemptions and the fact that institutional money managers are paid for performance. To keep their bonuses coming in, they’ll sell their mother if it will offset a loss that would otherwise place them below their benchmarks. This creates a waterfall effect and brings everything down, good, bad, ugly, or magnificent. In bear markets, buy and hold is a crock.

Periodic rebalancing is essential to avoid going over Niagara Falls in a canoe -- with our entire net worth inside. Even if we survive, the money is all washed away.

My asset allocation is based upon ongoing research of major demographic, geopolitical and macroeconomic trends. But these trends are best observed during the 70% of the time the market is going up. I refuse to give it all back during the 30% of the time the market is falling.

It’s the same for individual stock selection. Right now I’m salivating at the prospect of buying the best sectors, which for me will probably be energy, agriculture, mining, and the raw materials that nations like Canada and Australia will supply to developing economies like India and China. I can’t wait until Deere (NYSE:DE), Syngenta (NYSE:SYT), Archer Daniels (NYSE:ADM) and Lindsay (NYSE:LNN) – to name just a few individual stocks in one of my favored sectors – decline to great buy points. But I won’t buy at just any old price and I wouldn’t – and didn’t -- hold them through a major decline.

I wish investing were sure enough, steady enough, and simple enough to simply buy quality and hold it. And, occasionally, very occasionally, I find something that will rise slowly in good markets but decline only grudgingly in bad ones. One such that I’ve owned in our Growth & Value Portfolio in Investor’s Edge ® is MGE Energy (NASDAQ:MGEE) We bought it in 2000 at 21 and today it’s at 30. But 9 points in 9 years is hardly worth writing home about. We keep it because I consider it a growth utility that regularly increases its dividend so it’s an anchor in the portfolio – both up and down.

Why don’t I have more of these I’m willing to hold through thick and thin? Because the simple truth is that the market direction itself will determine 50% (in the good times; something approaching 100% in the bad times) of the price of your stock.

Don’t just take my word for it. Take a look for yourself. The following chart is courtesy of my friend and competitor Sy Harding (386-943-4081, StreetSmartReport.com. I believe reading Sy’s book, Beat the Market the Easy Way!, or his newsletter, StreetSmartReport, is time well spent.) The chart shows the actual results of a buy of the S&P 500 initiated 12 years ago and held until today.

click to enlarge

A buy-and-hold approach in mid-1997, with the S&P 500 at 900, would have made you feel great in 2000, when it hit 1550. Of course, by 2002, when it retreated back to 900, you might not have felt as wealthy. (You weren’t.) Then again, by simply holding on for another 5 years, you made it all the way back to 1550 again. (Whew! Dodged another bullet.) Of course, holding until today brought you right back to 900. So you are rewarded for 12 years of fealty with an emotional roller coaster and the grand sum of $0 in profits.

I don’t claim to be able to pick the absolute top and the absolute bottom. I don’t claim to have a “Secret Method” that I’m willing to share for only $19.95 (0r $199.95, more typical of the going price.) And I believe anyone that tells you either of these things is dangerously delusional or an outright liar.

But what I can do is sell some of our holdings when the market is beginning to look toppy, sell more when it goes beyond all reasonable expectations, sell more when it hits the ridiculous, and sell the rest as it turns over. I can also start to buy when everyone is panicking, buy more when it declines further, buy more at the depths of despair, and buy the rest as it begins to recover. At this we’ve been rather successful, stair-stepping out in 2000, buying in 2002-2003, selling in 2007-2008 and catching almost the exact day – by sheer luck, I assure you – of the bottom thus far in 2009. (See our article here for confirmation of this most recent call.) We didn’t get the exact tops or bottoms, but we got out in the topping area and back in at the bottoming area. I don’t expect to be, or strive to be, right 100% of the time. If I can be right just more often than not – and act accordingly rather than be paralyzed with fear based on others’ panic or unwilling to sell based on others’ euphoria – we’re ahead of the game.

If you’re going to own shares of companies, the price of which are determined mostly by the direction of the market, you’d better pay attention and get the market direction right, or make it less important by judicious portfolio rebalancing, which is what we do. If this was easy, anybody could do it. When it gets so easy that anybody can do it, that’s your red neon light flashing that it’s time to rebalance into more and more cash.

That said, where do we stand today? I believe that red neon light is flashing. Too many people are whistling “Happy Days are Here Again.” I think they’re whistling past the graveyard.

Take a look at the chart below which I constructed because I believe other comparisons with previous bear markets rest on a false assumption. Others accept the standard definition that a bear market occurs whenever the S&P 500 declines by somewhere close to 20% regardless of duration. That’s just plain crazy. If the market plunges 20% in a day, but recovers the next day, should we include that as a “bear market?” I say no, but others, by including the 2- or 3-month panics listed below as the first three “bear markets” do include them.

A bear market should be defined not only by its severity but by its duration. We can handle a 20% drop without much pain as long as the recovery begins immediately. True bear markets however, drip, drip, drip away and steal our resolve. If you include the three 3-month panics that were over before true fear could set in along with the four real bear markets I cite below, you’d feel pretty good about where we are right now: the “average” (if there were such a thing) bear lasts a year and 10 months and declines 45%. Well, heck, we’ve already been at this a year and 7 months and we were down as much as 52%. Therefore we must have seen the bottom back in March, right? I don’t think so.

I have removed the 3-month “bears” that were blessedly brief and their recoveries quick and joyful. In doing so, we find the average decline of the four bear markets with both a 20% decline and a duration of greater than 12 weeks was 60.8% and took roughly 3 years to work themselves out. By this more accurate measure, this would be the shortest bear of the 5 since 1929. For that reason I believe this fine rally will shortly end.

Chart © Joseph L Shaefer, 2009

If I’m right and buy and hold could be, yet again, a dreadful mistake, why do so many experts tell you that it is the only way for the “little guy” to make money? Because it is in their financial interest to tell you that. Television, newspapers, magazines, etc. make their money from advertising. To keep the advertisers, they have to have content. To get a steady stream of Talking Heads for content, they turn to Wall Street, where Talking Heads are only too happy to appear frequently. These “experts” know they need you to leave your money with them 100% of the time so they can day-trade it, buy sub-primes with it, or whatever. If you removed your money in every bear market, protecting yourself from further declines, their bonuses would plunge to nothing. Worse case, they could be out of a job. Of course, they tell you that buy-and-hold is the way to make money. Their livelihood depends on it. If they really believed it, why would there be any turnover in mutual fund portfolios, except for redemptions – let alone a typical 70%-100% a year?

There’s a time to hold for the long term, and I do it often once a long-term trend is in place. But in a bear market? Buy-and-hold plays right into the hands of those who would separate you from your money.

Disclosure: Mostly in boring, safe cash equivalents, with some income, gold and inverse ETFs like EUM, SH, SEF, REW, and PSQ.